The extra risk, relative to the bottom portfolio, stems from the risk differences between each position. The Russell 2000 invests in small-cap stocks and the intermediate-term corporate index invests in investment-grade bonds. The second portfolio becomes less risky because the S&P 100, which is comprised of 100 of the largest U.S. companies, is less risky than the Russell 2000. Credit bonds also correlate with stocks more and are more volatile. Even though the bonds are longer duration, the main source of risk is the higher correlation between credit bonds, which could default, and short-term Treasury bonds.

Other Troublesome Indexes

ETF issuers exacerbate the weakness of stock-to-bond every time they launch the next innovative ETF. Low- and minimum-volatility stock ETFs contribute much less risk to diversified portfolios than their cap-weighted parent indexes. Stock-to-bond classifies both as stocks. High-yield bonds fall into the bond category but often behave more like stocks. Commodities and alternative strategies fit poorly in both categories.

Complification

Most users of stock-to-bond respond by adding rules to the simple stock-to-bond measure; they complify it. What does complification look like? A portfolio targets a 60/40 stock-to-bond ratio, but only 20% of the bonds can be in high yield. International and global funds are capped at 25%, and small-caps are capped at 20%. Commodities count as partial stocks and partial bonds. Then come new rules for high-quality stocks, low-volatility stocks, and whatever else. The simplicity of stock-to-bond is long gone and what is left are a bunch of rules only a Pharisee could be proud of.

SEE MORE: The Foibles of ETF Expense Ratios

Risk Budgeting

Risk Budgeting improves risk management by overcoming the challenges faced by stock-to-bond. Instead of classifying securities into two groups, Risk Budgets analyze securities based on how much risk they contribute to the portfolio. Risk-Budgeting solutions require more work behind the scenes. Having a set of measures to help estimate risk is a crucial step. Understanding the role of correlation, and how it changes with the level of allocation and volatility, is also important. When implemented well, Risk Budgeting provides the investment manager with an explicit understanding of the risk tradeoffs across securities and insights on how to improve risk allocation.

Completing the complicated work behind the scenes allows a practitioner to present individual clients a single risk number. From this number, clients understand how their portfolios relate to a common benchmark and where they sit on the risk spectrum. Improved portfolio design and better client relationships await.

Scott Kubie is the Chief Strategist at CLS Investments, which is a participant in the ETF Strategist Channel.